FINDING VALUE / CASEY DAILY DISPATCH WEEKEND EDITION ( HIGHLY RECOMMENDED READING )

Weekend Edition

Dear Reader,

Welcome to the weekend edition of Casey's Daily Dispatch, a compilation of our favorite stories from the week for the time-stressed readers.

Finding Value

By Chris Wood

I’m often asked by family and friends outside the world of finance (and, I guess, by those inside that world too), how do you pick stocks? My initial answer, which is probably quite annoying, is always, “Well, it depends on what kind of stock you’re looking for. Do you want an overvalued stock to short, an undervalued stock to go long, a stock to buy and hold for a long time, or a stock that has a chance of giving you a big return in the short term but could also lose you a bunch of money, etc.?”

If I haven’t completely lost them by this point, the answer I most often hear is along the lines of, “I want something I can buy that doesn’t require a lot of work and that I can hold for a nice return over a few years.” Of course there are those who want the big run-up in the short run, but after I remind them there is usually a high probability that they will lose big with such stocks, their second answer is generally the most popular one.

What these guys and gals are essentially saying is that they are looking for stocks that are currently undervalued based on their fundamentals. Such stocks are the ones that you can buy and wait for the market to realize their fundamental value, what many investors call their intrinsic value.

If you're looking for the same thing, it just so happens that over the past year, we’ve been developing and back-testing a proprietary stock screening methodology to isolate undervalued and especially attractive companies. And while we can’t divulge the entire model (which is rather complex and involved), we can discuss two important metrics.

The first metric is the P/E ratio. When it comes to valuing stocks, the price/earnings ratio is one of the oldest and most frequently used metrics. We screen for stocks with positive earnings and current P/E ratios (based on reported trailing twelve-month earnings) less than or equal to 7.0.

Most investors look at the P/E ratio simply as the multiple of earnings that the market is willing to pay for a given stock. For instance, if XYZ company earned $2.00 per share over the past year and trades for $20.00, the multiple the stock is trading for (the P/E ratio) is 10.0. Investors then compare that P/E to others in the industry and decide if the stock is over- or undervalued based on that comparison.

Most investors don’t understand that the true significance of the P/E ratio is derived only by taking its reciprocal, which gives you the earnings yield. Earnings yield is the percentage of what the company earns each year per share, based on the price you paid for it. If you buy a stock at $50 a share and it earns $8 a share, you have an earnings yield of 16%. That doesn’t mean you get 16% in cash. It means that the company’s value in relation to your purchase price went up 16% that year.

When a stock is selling at 6 times earnings (P/E ratio of 6), that means it’s earning 16.67%. Tell investors that a stock has a P/E ratio of 6, and it could pass right over their heads. But tell them that they’ll earn nearly 17% on their money, and you’ve got an audience.

We use the P/E ratio not as a comparative tool to examine stocks relative to others in the same industry, but as an absolute tool to screen for value. That is why we only look for stocks with an earnings yield above 14.3% (P/E ratio of 7 and under), since we believe this is the least return you ought to expect for risking your money on stocks today. If, over time, alternative investments materialize offering similar yields but with a lower risk profile than that of common stocks, we’ll either invest in those or alter our securities screens to require a higher earnings yield.

Price-to-book is another metric we use to find undervalued stocks. We screen for stocks with a price-to-book value less than 1.0. Considering only those stocks selling at a price below book value can be viewed as a form of insurance.

How?

With our apologies to those of you already well familiar with the basics, book value, called stockholders’ equity on the balance sheet, is the theoretical liquidation value of a company’s net assets (since equity equals assets minus liabilities). Thus, book value can be thought of as what would be left over for equity suppliers after all assets had been sold and all creditors repaid.

Suppose a company had net assets of $500 million and 25 million shares of stock outstanding. Its book value would be $20 a share. If the company stopped earning money and went out of business, you would still receive $20 for every share you owned. If you paid $20 a share originally, you haven’t lost any money. If you paid less than $20, the liquidation will actually make you a profit.

With these two screens alone, a P/E of 7.0 or below and a price-to-book below 1.0, you can weed out literally thousands of stocks that probably aren’t worth your time and home in on those that deserve, at least, a closer look.

Just in case you’re wondering, our new model has a perfect batting average thus far (even though it’s only had two at bats). The two stocks we’ve recommended based on the model have generated annualized returns of 42% and 132%, respectively.

The TIC Report

By Bud Conrad

The latest Treasury International Capital System (TIC) report shows some increases in foreign investment back into the United States. The most comprehensive measure of net flow accumulated over the last 12 months still shows a net negative investment:


There was a return to foreign investment in long-term securities. The chart below compares the long-term security investments against the trade deficit. They both dropped dramatically in the worst of the crisis and are now showing some recovery.

One dramatic shift is that foreign investment moved away from short-term in three-month T-bills that was a big part of flight to safety during the worst of the crisis. The chart shows the large purchases have mostly stopped. The short term has paid no interest, so foreigners are now looking for better returns and perhaps are less fearful.

David here. Speaking of Bud, on Monday he was on Fox Business discussing the situation in California. He participated in three segments altogether, with the best one (in my opinion) being a discussion of Google and China.

You Ain’t Seen Nothing Yet!

For a moment, put yourself into the well-polished shoes of the president.

You’ve worked all your life to get to your position at the very apex of global power. Feels pretty good, eh?

Except for a burning sensation on the back of your neck you suspect is connected with Brown’s win in Massachusetts.

Damn!

After quickly reacquainting yourself with presidential powers related to ordering assassinations and being disappointed, you return to your calculations.

What can you do to bring your former supporters, those fickle bastards, back under your rainbow-colored tent?

After all, even after your $1.8 trillion in deficit spending last year, the job picture still sucks, and so does the housing market.

The public has caught on to your cozy insider dealings with the big banks.

The threat of global warming you were so vocal about has been exposed as a farce.

And now your universal healthcare legislation is unraveling – and with it, your last best chance for a place in history as something other than a cultural footnote.

Oh, the humanity! Why can’t these fools realize that you know what’s best for them? That with just a bit more patience, you’ll lead them to a promised land of high-speed trains, affordable healthcare for all, and green jobs aplenty?

But, noooo. Where you see high-speed trains, Mr. John Q. Stupid sees government make-work and waste. Where you see universal healthcare, the two-thirds of people who already have health insurance see nothing but higher costs, more taxes, and rationing. Green jobs? A joke.

Well, if they think that they can lay you low that easily, they’ll have to think again. It’s time for Super O to show them how to take a punch and come back swinging.

Rolling up the sleeves, an effective way of being seen as regular folks, you begin scribbling a list.

One. Pretend to “take on” the banks. If you can project enough righteous indignation and talk ardently enough about public retribution, maybe people will forget that we just spent hundreds of millions bailing those fat cats out, or that the worst offenders in the whole mortgage mess were the government’s own Fannie, Freddie, and the FHA. And they won’t remember that until recently, the financial services sector was the single largest component of the economy. All that really counts now is that people think we are laying them low, even if we actually aren’t.

Two. Geithner’s got to go. Hey, why should you take the blame, when you can pass it on down the chain? And to a former big banker, to boot! (Note to self: Be sure to use the phrase, “As your president, I am ultimately responsible and the buck stops here,” before blaming it on Geithner anyway.)

In the meantime, set the stage by rearranging the line-ups at photo ops to slide Geithner down the line and bring Volcker into the photo.

And since we’re at it, maybe you better bring Barney Frank more into the picture, too -- with that whole Brown thing, he could be in trouble come November, and then where would you be?

Three. Cap and trade? What cap and trade? When anyone brings up the topic, just pretend you can’t hear them, or tell them they must be mistaking you for some other guy.

Four. Direct handouts. No more talk of tax breaks or investing in green jobs -- it’s time to just start handing money out. Forget the high-speed trains and start building bridges and fixing roads. So what if it didn’t work the first time; the second time’s a charm, they say.

Five. Blame the Republicans for a failure in healthcare. Hey, they had their chance to get in line with your legislation, now it’s all on them. Meanwhile, just after blaming them, be sure to make conciliatory noises about working with both sides of the aisle.

Six. Push comes to shove, war with Iran? The Israelis are ready to go. So, maybe a quiet nod to the right folks could get the show on the road.

Hey, that whole “commander in chief” thing during a period of war certainly worked out for Bush, right?

Laying down your pencil, you rock back in your comfortable leather chair, survey your posh surroundings, and remind yourself how much you like the place. “Get ready, America,” you say out loud to no one but yourself, “you ain’t seen nothing yet!”

Especially now that corporations and unions are free to contribute as much as they want to our campaigns. If they want to play, they’re going to have to pay… and big!

Now, if only that burning sensation on the back of your neck would go away.

States Gone Wild

About five years ago, state government officials hereabout could be heard pondering on all the fruitful plans they had for spending the surplus that had sprung up thanks to the bubble in taxes linked to investment income and real estate. I well recall thinking how remarkably short sighted they were to assume that the good times could last forever. Thus, instead of building a cushion for the proverbial winter, like the industrious ant in Aesop’s fable, they made like the grasshopper and quickly squandered the surplus.

Now that the big chill is here, this state – and 47 others – are now out of money and out of luck. A comprehensive report recently released by the Center on Budget and Policy Priorities provides all the details. The opening paragraph gives an informative glimpse at the situation.

The worst recession since the 1930s has caused the steepest decline in state tax receipts on record. As a result, even after making very deep cuts, states continue to face large budget gaps. New shortfalls have opened up in the budgets of at least 39 states for the current fiscal year (FY 2010, which began July 1 in most states). In addition, initial indications are that states will face shortfalls as big as or bigger than they faced this year in the upcoming 2011 fiscal year. States will continue to struggle to find the revenue needed to support critical public services for a number of years.

The report also includes the following chart that graphically presents what I think is actually an optimistic case.

Another relevant quote…

If revenue declines persist as expected in many states, additional spending and service cuts are likely. Already 20 states have taken actions to close mid-year budget shortfalls. The majority of the actions taken so far were spending cuts made by governors using their power to maintain budget balance. Budget cuts often are more severe later in a state fiscal crisis, after largely depleted reserves are no longer an option for closing deficits.

Expenditure cuts are problematic policies during an economic downturn because they reduce overall demand and can make the downturn deeper. When states cut spending, they lay off employees, cancel contracts with vendors, eliminate or lower payments to businesses and nonprofit organizations that provide direct services, and cut benefit payments to individuals. In all of these circumstances, the companies and organizations that would have received government payments have less money to spend on salaries and supplies, and individuals who would have received salaries or benefits have less money for consumption. This directly removes demand from the economy.

In our sleepy New England town, there’s a big debate going on now about how to maintain school funding without raising taxes and cutting services. Parents are up in arms about the idea of cutting sports programs from the curriculum.

There is always something of a lag between a change in circumstances and our reaction to it. At this point, a surprising number of people still haven’t come to the realization that the local schools can either fund a ski team or pay for a science teacher… but they can’t have both, and at the rate things are going, they may not be able to have either.

And that, dear reader, is that for this week. See you on Monday!

David Galland
Managing Director
Casey Research